Module 2: Is it material? Understanding the concept of ‘materiality’

Information, events, facts and topics might all be interesting, but when does something become relevant, important, or ‘material’?

Those who deal regularly with the legal system, financial statements and continuous disclosure rules for public exchanges will be familiar with the concept of materiality.

Let’s have a look at a few different definitions.

The Australian Conceptual Framework for Financial Reporting provides the following definition of materiality in relation to financial statements: 

Information is material if omitting, misstating or obscuring it could reasonably be expected to influence decisions that the primary users of general purpose financial reports make on the basis of those reports, which provide financial information about a specific reporting entity. In other words, materiality is an entity-specific aspect of relevance based on the nature or magnitude, or both, of the items to which the information relates in the context of an individual entity’s financial report.

Similarly, in the context of climate-related financial disclosures, the Australian Sustainability Reporting Standards defines information as material if “omitting, misstating or obscuring that information could reasonably be expected to influence decisions that primary users of general purpose financial reports make on the basis of those reports, which include financial statements and climate-related financial disclosures and which provide information about a specific reporting entity.”

The Supreme Court has held that a fact is material if there is:

“a substantial likelihood that the disclosure of the fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” 

The US Financial Accounting Standards Board states:

“The omission or misstatement of an item … is material if, in light of the surrounding circumstances, the magnitude of the item is such that it is probable that the judgement of a reasonable person relying upon the report would have been changed or influenced by the inclusion or correction of the item.”

While there are some differences in these definitions of materiality, we can see some persistent concepts and themes:

• The receiver of information has a primary role to play in determining whether information is material or not
• Information becomes material if it is likely to affect the decision-making of the audience that the information is intended for
• Materiality is situation or entity-specific, and it is to do with relevancy
• The degree to which information would change judgements or decision-making is important in determining whether that information is material.

Here’s a very simple example of materiality in action:

John intends to make dinner that night for his wife, Priyanka. At 5pm, Priyanka, calls John to tell him that she is on her way home. John starts preparing dinner.

At 7pm, Priyanka still isn’t home, and now their dinner is getting cold. When Priyanka finally walks through the door at 8pm, John asks ‘what happened?’

Priyanka tells John she had to stop by her sister’s place on her way home.

“Why didn’t you tell me you were going to stop at your sister’s place when you called at 5pm?” John asks. “I would have started making dinner much later.”

In this example, the information that Priyanka was going to stop by her sister’s place on her way home was material, because it would have led John (the intended user of the information) to make dinner later, and not just a little later, but much later. On another day, depending on the circumstances, the information that Priyanka was not coming directly home may not have been relevant to John for his decision-making purposes.

The information that Priyanka was not coming directly home that night was also only material to John; it was not relevant to the couple’s neighbor, Steve, or Priyanka’s boss, Carol.

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When an organisation conducts a materiality assessment to determine its material topics, the organisation is asking itself: Is the topic relevant to us?

There are two perspectives that an organisation can apply when considering the ‘relevancy’ of a topic.

• Whether the organisation actually does, or has the potential to, cause positive or negative outcomes relating to the topic. This is known as impact materiality, and it considers the organisation’s effects on people and the environment.
• Whether the topic actually does, or has the potential to, affect the organisation financially. This is known as financial materiality, and it considers the effects of people and the environment on the organisation. These financial effects are referred to as sustainability-related risks and opportunities.

An organisation could identify hundreds of sustainability-related impacts, risks and opportunities, yet not all of them will be relevant, or material, for management and reporting. An organisation must consider the significance of each impact, risk and opportunity to work out whether it should publish information about it. Significance is measured by severity (scale, scope, irremediable character), magnitude, likelihood and nature, depending on what is being considered.

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See slide 3 for a high-level comparison between impacts materiality and financial materiality.

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It’s important for organisations to consider why they are undertaking a materiality assessment, who the intended audience is, and what reporting frameworks or legislative requirements apply, so that they can choose the most suitable perspective – impacts, financial effects, or both - to approach materiality.